Expert SMSF insights
Private Binding Ruling could expand on tax deductions
By Mark Ellem
- Recently issued Private Binding Ruling
- What is a "Future Service Deduction"?
- Effect on losses when paying pensions/claiming ECPI
Private ruling opens the door for little known SMSF benefit
A recently issued Private Binding Ruling (PBR) that we lodged on behalf of an SMSF trustee, has potentially expanded the ability for an SMSF to claim a little known, but potentially substantial, tax deduction when paying out a death benefit.
Used in the right circumstances this deduction, referred to as the ‘future service deduction’ can result in the remaining members, and future fund members, paying no tax on their employer contributions for many years to come.
But first, let’s deal with the unpalatable part of this “strategy”, it requires a member of the SMSF to actually die! Further, that member needed to have insurance and also their death needs to occur before their 65th birthday – in fact the earlier, the greater the potential tax deduction and resulting tax benefit. Morbid, I know, but it’s being able to identify an opportunity from such a tragedy that can provide some future tax benefits to those loved ones who remain.
What is a “Future Service Deduction”?
Generally, an SMSF can claim a deduction for premiums paid on insurance policies, in respect of a member, that provide insurance cover in the event of:
- a superannuation death benefit (including a terminal illness benefit);
- a disability superannuation benefit;
- a temporary disability benefit paid in the form of an income stream.
This means trustees will generally be able to claim for the cost of any life, total and permanent disability (TPD) or income protection policy held to provide insurance cover for one or more members.
An alternate to claiming a tax deduction for the actual insurance premiums is the option of claiming a deduction for the future liability to pay benefits based on the actual cost of providing the death or disability benefits which arise in each year.
The general understanding is that the alternate future service deduction is available if the SMSF trustee chooses not to claim a deduction for the cost of death or disability insurance premiums in respect of that year and the fund pays a superannuation death or disability benefit in consequence of a member’s termination of employment (or pays a benefit because of a temporary inability to work). That is, for the SMSF to be eligible to claim a deduction the member must have been employed and the payment must have been made in consequence of their termination through death or their inability to work.
The deduction available to a fund is calculated using the following formula:
- Benefit amount = the value of the super interest used to pay a lump sum or pension, or in the case of income protection benefits paid to the member, the amount of payments received during the financial year
- Future service days = days from the date of employment terminating to the member’s last retirement date (generally age 65)
- Total service days = future service days plus the member’s existing service days.
Where an event has occurred, which may entitle a trustee to make the choice to claim a future liability to pay benefits deduction, they may wish to consider the following:
- the deduction will generally not be available where the relevant member was over age 65;
- where the trustee elects to claim the deduction, they will not be able to claim a deduction for any insurance premiums paid by the fund in that income year or future income years (this is why the Future Service alternate is regarded as unique to SMSFs as other larger funds would generally not make such a claim in respect of one member, preventing the fund from ever claiming insurance premiums in relation to other fund members);
- as the deduction reduces with age it may be better to claim the cost of the premiums where the member is approaching age 65;
- where the member’s benefit is large compared to the level of insurance, the future liability deduction should provide a larger deduction compared to claiming the insurance premium as a tax deduction;
- where the deduction exceeds the fund’s income, the resulting tax loss can be carried forward to future years.
Beware of SMSFs paying pensions and claiming ECPI – effect on tax losses
Generally, the size of the deduction for the alternate future service claim will result in the SMSF having a carried forward tax loss. Whilst this can be carried forward, the amount of the loss will be reduced by any ‘net exempt current pension income’. An SMSF will have ‘net exempt current pension income’ where it is paying a retirement phase pension to a member and as a consequence is claiming Exempt Current Pension Income (ECPI), that is, income that the SMSF can claim as being exempt from the 15 percent tax rate that normally applies to income derived by the fund. Net ECPI is merely ECPI less the expenses that are deemed to have been incurred in earning the ECPI. Generally, such expenses are simply the portion of expenses that are not deductible due to the SMSF having ECPI.
To limit the effect of net ECPI on tax losses, the simple strategy is to remove any retirement phase pension accounts (for example, by effectively transferring such pensions to another superannuation fund). This leaves the SMSF with members who only have accumulation accounts, thus no claim for ECPI and no reduction to any tax losses brought or carried forward.
Transferring out death benefit pensions – easier post 30 June 2017
From 1 July 2017, a member receiving a death benefit pension, including a pension that reverted to them due to the death of another member (for example, their spouse), can roll over death benefit entitlements to other funds without having to wait for the expiration of the ‘death benefit period’ (which applied prior to 1 July 2017). Once the death benefit pension has been rolled over it will continue to be recognised as a death benefit superannuation interest and must be used to commence an income stream from the recipient fund or cashed out as a lump sum.
Consequently, this change to the rules allows for an easier removal of death benefit pensions from an SMSF and transfer to another superannuation fund, so that there is no reduction in any tax losses available as a result of a Future Service claim. To read more about this change to the rollover of death benefit pensions refer to our recent blog article “Making it easier to transfer death benefit pensions”.
Contributions tax holiday – use choice rules
Whilst at this time the maximum number of members of an SMSF is four (Government policy remains to increase this from four to six), a unique aspect of a superannuation fund is that unlike other trusts, it is not subject to the rule against perpetuities. That is, a superannuation fund can go on forever. So, an SMSF is truly a generational vehicle that can be used by future generations.
Importantly, where a family member can exercise choice in relation to where their employer superannuation contributions are directed, they can choose to have their employer contribution directed to the SMSF that has the large tax loss, resulting from a large future service deduction, brought forward from a prior year. The tax loss will offset the assessable contribution and effectively the assessable contribution will not be subject to the 15 percent tax rate that would normally apply to these contributions – essentially the member can enjoy a contributions tax holiday, for that year and maybe for many future income years, depending on the size of the tax loss and the assessable contributions.
Future Service deduction – case study
Let’s take the scenario of Will, a member of an SMSF, together with his wife Kate. Unfortunately, Will dies at age 42. He was employed up to date of death (this is an important requirement for eligibility for the Future Service deduction alternate). For the purpose of this example, we have assumed Will’s service period commenced in 2000 (note that the calculation is based on whole years for this example, however, the formula requires it to be based on days), giving him a current service period of 20 years and a future service period of 23 years (being years to age 65). There is life insurance of $600,000 and together with Will’s current accumulation balance of $700,000 means the death benefit payable is $1.3m.
If the SMSF trustee(s) elects not to claim the insurance premium paid for the year and instead choose to claim a tax deduction under the alternate future service liability deduction provision, the deduction amount is calculated as follows:
$1.3m x 23/43 = $695,349
Using the fund’s tax rate of 15 per cent, the tax benefit to the SMSF is $104,302. If the fund doesn’t have enough taxable fund income to offset this deduction, it can be carried forward (but note above comments about reduction to any brought forward tax loss where an SMSF has net ECPI).
So, just to state in another way, rather than the fund claiming for the insurance premium, say $2,500, the SMSF has claimed a deduction of $695,349. Now, as stated above the fund could not claim any deduction in the future for insurance premiums, however, the SMSF would have to earn $695,349, after allowable deductions, before it would start paying any tax. That includes assessable employer and member contributions that are directed to the SMSF. Again, that’s $104,302 of actual tax that the fund will not pay on net assessable investment income and assessable contributions – take that to the bank!
But Future Service deduction is not as simple as it sounds
There has been a number of Private Binding Rulings (PBRs) issued by the ATO on the issue of claiming under the Future Service alternate, as well as an Interpretative Decision. One of the PBRs implied that the SMSF would need to make an election prior to the death of the member. Common practice was to elect to claim under the Future Service alternate in the return that relates to the income year in which the member died. This outcome appears to have been overturned in the later Interpretative Decision.
In another PBR the entitlement to claim a deduction under the Future Service alternate was again rejected by the ATO. The focus in this ruling was on the fact that the member passed away in the 2012 income year, however, the last premium paid by the fund was in the previous 2011 income year, as the member passed away before the annual premium was paid (in the year of the member’s death).
As there was no premium paid in the year that the member died, there was no entitlement for the fund to claim a deduction under the Future Service alternate and consequently the fund was unable to make an election to claim the Future Service alternate.
The subsequently released Interpretative Decision in 2015 (ATO ID 2015/17), was interpreted by many as a green light for SMSFs claiming the Future Service alternate. However, my view, at the time the Interpretative Decision was released, was that it only addressed one specific aspect of the Future Service alternate, being whether the election to apply the Future Service alternate can be made after the member has died (refer to the PBR first mentioned above).
In contrast to the first PBR mentioned above, the Interpretative Decision said that “A valid choice can be made under subsection 295-465(4) of the ITAA 1997 (the Future Service alternative) by the trustee after the death of an insured fund member”. Effectively this Interpretative Decision countered the outcome of the relevant PBR.
However, in my view the Interpretative Decision did not address other aspects of the Future Service alternate. These are now discussed:
Payment made in consequence of employment
The facts in the Interpretative Decision include that the deceased member was employed up until their date of death. One of the eligibility requirements for the Future Service alternate deduction is that the payment is made “in consequence of termination of employment”. The Interpretative Decision states facts that the “deceased member was employed up until their date of death”, however, what would be the case if the member had left employment earlier, for example due to ill health and died sometime later? Would the death benefit paid by the fund be “in consequence of termination of employment”?
Convenient facts of ATO ID 2015/17
The facts of this Interpretative Decision are also very convenient as they provide the perfect storm of events that fit perfectly into the requirements of the Future Service alternate deduction requirements. The insurance premium, receipt of insurance proceeds, death and super death benefit payment all occur in the same income year. So whilst the election can be made after the member has died (in fact the Interpretative Decision states that the election can be made up until the date of lodgement of the return for the relevant year that the choice is being made), what if the circumstances are not so convenient as the Interpretative Decision?
This is what happened with the circumstances of an SMSF that we dealt with recently.
Latest PBR – perfect storm not required
In the PBR that we lodged on behalf of an SMSF trustee, we asked the ATO whether the SMSF could claim the Future Service alternate given the facts below. The main issue was that all of the relevant events did not occur in the one financial year. This meant that there was no perfect storm of events that aligned with ATO ID 2015/17.
- the member (under age 65) died;
- insurance premiums were paid monthly up until the month of death;
- the member was employed up until their death.
- The SMSF received the insurance proceeds;
- The SMSF paid the death benefit.
Our concern was whether the Future Service alternate could be claimed in 2018/19 as there was no actual death benefit paid in that year. Also, as there was no insurance premiums paid in 2019/20 there could be no alternate, that is, the Future Service alternate claim, rather than claiming the premiums (as there were none). These concerns were borne out of our understanding of ATO ID 2015/17 and the previously issued PBRs.
However, the PBR issued by the ATO stated that the SMSF could claim the Future Service alternate, in the 2019/20 year, even though no insurance premiums have been paid in that year. Our interpretation of the ATO’s reasoning in the PBR is that the SMSF trustee(s) can elect not to claim the insurance premiums paid in 2018/19, but claim under the alternate Future Service option in 2019/20. That is, the SMSF trustee(s) are not restricted to claiming under the alternate Future Service option in the income year in which they elect not to claim the insurance premiums. Where the election is made, the Future service deduction claim can be in the subsequent income year.
Whilst the PBR only applies to the specific fund, it does provide further guidance and some clarification that an SMSF will not be penalised where the member dies nearer to year end and insurance proceeds are received and the death benefit paid in the subsequent financial year.
However, based on prior PBRs, it would be a requirement for there to be insurance premiums in the income year that the member died. If in an income year a member died and there were no insurance premiums paid, in respect of the member who died, as there would be no entitlement for the fund to claim a deduction for insurance premiums, there would be no ability for the SMSF trustee(s) to make an election to claim a Future Service deduction. To this end, consideration should be given to monthly insurance premiums over annual premiums, giving a greater chance that there will be an insurance premium paid in the income year the member dies.
Consideration of Future Service claim where SMSF member dies
For SMSFs that have the tragedy of the death of a member, prior to them attaining age 65 and that member had insurance cover, consideration should be given to whether the SMSF can claim the Future Service alternate as part of a strategy to benefit remaining and future members by reducing the tax applicable to future fund earnings and importantly, assessable contributions.
Despite the successful outcome of this PBR, an SMSF contemplating a Future Service deduction may still wish to consider whether to obtain legal advice or apply for their own PBR (there is still an issue of what “in consequence of termination of employment” actually means). However, for an SMSF that is successful in claiming the Future Service alternate, it opens up some great planning opportunities for those who remain and for future generations – a legacy of the member who passed away.
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